Saturday, 22 July 2017

Today’s post assesses the news that the European Securities
and Markets Authority (ESMA) has had its decision to reject Polish rating
agency FinancialCraft’s application to be registered under EU regulation upheld,
after an appeal was lodged to the Joint Board of Appeal of the European
Supervisory Authorities. In this post we will look at some of the reasons for
the rejection and assess whether the grounds for rejection were fair,
especially in relation to recent instances of the larger rating agencies
flouting the European regulations.

FinancialCraft, a
small Polish rating firm, had applied in 2016 to be registered as a recognised
Credit Rating Agency under the EU Regulations on Credit Rating Agencies; on the
8th of December 2016 that
application was rejected by ESMA, the supervisory body tasked with
supervising the CRA sector. In accordance with the regulations, which allow for
a second application, FinancialCraft swiftly reapplied, with the same rejection
following. As a result of this, FinancialCraft then appealed to the Joint Board
of Appeal of the European Supervisory Authorities, with the appeal set to be
heard (without FinancialCraft and the ESMA present, as per their instruction)
on the 20th July 2017. The basis of ESMA’s rejections were that the application
was incomplete, with a number of details regarding methodological approaches,
internal policies and other elements missing or only broadly addressed. After
two formal notices of incompletion, ESMA finally notified FinancialCraft that
it considered the application to be complete, and began an assessment of the
firm’s compliance with the regulations; however, upon this assessment ESMA
requested further clarification and FinancialCraft responded that it has ‘plans
to hire new resources upon commencement of credit rating activity’ i.e.
become compliant retroactively. It was on this basis that ESMA formally
rejected FinancialCraft’s application for a second time.

The terms of the decision of the Board to reject
FinancialCraft’s appeal are interesting. They acknowledge, almost immediately,
that one of the key stated aims of the EU Regulations was to increase
competition in the sector by encouraging small rating agencies to enter the
marketplace. Because this author has already
written on the practical difficulties of attaining that goal, it is not
worth revisiting this issue in any great detail. With regards to the
actualities of the appeal, the Board notes that FinancialCraft’s main argument
is that the information that ESMA requires was actually submitted and that,
essentially, ESMA’s repeated calls for detailed information are restrictive, as
‘the process must be stopped at some point because a description cannot be made
any more specific’. Also, FinancialCraft allege that ESMA’s demanding of proof
that FinancialCraft’s methodologies and have been tested and validated
represents ESMA ‘using technical requirements to prevent the appellant from
entering the market’. In response to this ESMA simply contested that ‘the
appellant’s grounds for appeal are not well-founded’ and that failure to
demonstrate compliance must result in
rejection. The Board, when making its decision, unanimously sided with ESMA and rejected the appeal, finding that
it is the firm’s responsibility to ensure compliance and that ‘merely quoting
from CRAR [the regulations] or pointing to existing laws is not sufficient to
demonstrate compliance’. Furthermore, the Board found that the management
structure (the Owner’s partner) was conducive to developing a conflict of
interest in relation to the opportunity to access fee information on rated
entities, and that with regards to providing details on methodological approaches,
there is not a case to be made by new entrants that methodologies cannot be
tested until entities have been rated. Ultimately, the Board sets a
particularly high standard for new entrants, meaning that every element must be
adhered to in the strictest possible form. So, what is the problem?

With regards to setting high standards, there is no problem –
it is pleasing to see supervisory bodies asserting their insistence that
standards will be met. However, we spoke
recently in Financial Regulation
Matters, based upon a forthcoming article by this author, about a recent push
by ESMA to develop competition within the sector, with the results being
frustration and an acceptance that ‘unfortunately,
successful implementation of these Articles [EU Regulations] has been hindered
by a lack of clarity in a number of key areas’. Furthermore, Moody’s was
fined only in June for breaching
the credit rules, and the punishment was determined to be apt at €1.24
million. As Frank Partnoy noted recently, post-crisis reforms have had ‘little
impact’ for a whole host of reasons but, for this post, the issue is the
effect that these two stories have. It is worth clarifying at this point that
FinancialCraft’s application should have been rejected, because it would be
more than irresponsible to allow a firm registered status on the promise of
quality – retroactive compliance is simply not an option (to alleviate this
problem for new entrants, there is nothing stopping the agency conducting
sample or trail ratings, or even issuing some unsolicited ratings to provide
context). However, the question that must be asked is what is the perceived
result of these recent instances? The result is that for new entrants they must
be absolutely perfect in their obedience of the rules, whereas for established
agencies, their disobedience is accepted and only ever lightly punished. The
result of this is an implied barrier for access, whereby only the established
can afford to operate, and only the established will be allowed to make
mistakes. Whether or not everyone agrees with that conclusion is probably immaterial
because, in a sector that survives on perception,
the perception in this case is all that matters. The calls to increase
competition in the sector, and meaningful competition at that, are just that –
calls.

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